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What Is Hedge Ratio?

The hedge ratio is a powerful tool for predicting market behaviour, pinpointing the exact levels on an index where dynamic delta hedging will likely trigger significant buying or selling activity. It allows traders and investors to anticipate shifts in market momentum and identify where futures trading will intensify, providing a strategic edge.

The Predictive Power of Dynamic Hedging: Dynamic hedging is the process of continuously adjusting a hedge to stay neutral as market conditions change. When managing a non-linear position, such as options, with linear instruments like futures, the sensitivity to price changes (delta) shifts as the underlying asset’s value fluctuates. To maintain a balanced, zero-delta position, the hedge must be adjusted frequently. This constant recalibration is known as dynamic hedging, and it’s where the hedge ratio steps in, offering a roadmap for where these adjustments will occur across the market.

Why the Hedge Ratio Matters: The hedge ratio doesn’t just track individual adjustments; it scales this process up to the entire market, identifying key points on an index where hedging activity will ramp up. It also grades the intensity of this activity, giving traders a heads-up on where futures buying or selling will increase and to what extent.

Predictive Levels of the Hedge Ratio:
Neutral Zone (NZ): This baseline level indicates calm waters, where no significant hedging activity is expected. It’s a sign of stability before any movement begins.

Y1 and Y2 Levels: These early indicators represent low-intensity hedging but are the most sensitive to changes, making them crucial for spotting the first signs of increased market activity. When these levels move, it often signals that larger shifts are underway.

R Levels (1, 2, 3): As the hedge ratio climbs, the R levels signal progressively stronger dynamic hedging activity. Each step up indicates a higher likelihood of intensified futures trading, suggesting growing market pressure in one direction or another.

DR Level: This historically significant level is known to turn markets around. When dynamic hedging hits the DR threshold, it often triggers a substantial shift in market direction, making it a key predictive marker for major reversals.

B Ratio: The upper boundary of hedging activity, indicating extreme levels where the market is testing its limits. While dynamic hedging can still occur here, it often suggests unsustainable conditions that may lead to sharp corrections.

The hedge ratio provides more than just a snapshot of current market conditions; it offers a predictive map of where and when dynamic hedging will affect the market, allowing traders to anticipate changes and position themselves accordingly. With its ability to forecast future hedging activity and its impact on market trends, the hedge ratio is an essential tool for staying ahead in a dynamic trading environment.

Here is an example of a Ratio Table.

At the top is the index it relates to, the “SPX”, better known as the S&P 500.

Then the date they have been calculated for, American style.

On the left, in bold, is the previous day’s close.

In the middle of the column, in bold, is 3245 to 3255, which represents this index’s zone.

This is where this index should be if deprived of every other influence except derivatives.

And, therefore, becomes very significant the closer the market comes to expiry.

Arranged top and bottom are the ratio levels.

Y1 and Y2 are highlighted in yellow to denote they are minimal, and therefore susceptible to change the quickest, meaning they can be early indicators of any potential directional bias.

On the right are the various levels of Hedge Ratio, but please bear in mind these are exponential.

Also, there is a rough guideline as to how a market may react when encountering them.

For the record the SPX all time high is 3393.52, the close that day was 3386.15, and this expiry ended on the 21st Feb, the Friday immediately prior to the start of the Caronavirus collapse on the Monday.

Back on Friday the 20th March 2020 we published the Ratio Table opposite, which shows the levels for the forthcoming April expiry.

Therefore, the price on the left is the closing level of the S&P 500 on the 19th, as we publish before the market opens.

As we say above, beforehand we show where these exponential levels are, exactly, and how the market may react.

For the “B” ratios, the word we use is “dangerous”, as violent reactions can occur when hitting such a sudden huge amount of dynamic delta.

To date, the intraday low in the Caronavirus crash, in the SPX, stands at 2191.86.

For the record the Friday close was 2304.92, and the open on the 23rd was 2290.71 and the close 2237.40.

June 30th, 2017 by Richard